A succinct summary of key insights from recent subscription newsletters.

Thoughts on the market environment

We are dealing with an extraordinary situation, both in our lives and in the financial markets, and find ourselves in a state of limbo. We are skeptically eyeing the recovery of the economy while facing a pandemic that threatens to break out with new vigor at any time – and await a resolution of the current state of the market.

Will we really manage a return to new stock market highs in the face of an abysmal economy, a raging pandemic, social upheaval and so on? Or will the March bear market return with full force and surprise complacent investors?

A decisive area

As violent and fast as the March market crash played out, arguably the relentless rally that followed took even more investors by surprise. Nobody saw this coming! The disconnect between the economy and the stock market is baffling.

The current mantra is „Don’t fight the FED“ as enormous amounts of liquidity through monetary easing and fiscal stimulus by central banks and governments around the globe are the main driver behind this rally. 

Looking at past bear markets it quickly becomes clear just how unusual the current environment is: less than 17% of severe market drops (below -20%) go straight back up to near previous highs without a significant pullback. And never before has there been a similar recovery in such a short time – it is very rare indeed.

To me this rally stands on wobbly legs. The March bear market could return with full force and surprise complacent investors, that have returned to excessively speculative behavior already.

Small traders are taking extreme bets on a rally with 52% of their total volume on buying speculative call options – this was last seen in 2000 and levels above 45% led to losses every time in the last 15 years. Source: SentimenTrader

The stock market is battling with a decisive area at the moment and it can resolve either way. Defensive positioning allows me to patiently wait for a high probability indication that a new bull market regime has in fact started, whether that happens soon or much later.

The Meta Strategy

My systematic tactical strategy combines technical and fundamental economic inputs to gradually rotate a portfolio between different asset classes according to market conditions.

For a tactical asset allocation strategy a V-shaped recovery makes it hard to gain excess returns – prices recover so fast, that the re-entry into stocks is close to or above the previous exit. The real advantage is psychological: being out of the market during a harrowing crash is balming for frayed nerves. The tactical exit from stocks is akin to an insurance policy – it is not so much about where the eventual re-entry will be relative to the exit, but rather about avoiding a potential devastating loss that will happen eventually.

Currently technical indicators begin to show distinct improvement. The S&P 500 has returned above its long-term trend. But volatility stays elevated and the danger signal – the VIX futures term structure – is still active after managing to return to a neutral state for only a short period of time.

Fundamental economic indicators show horrific economic conditions. The hope is for a quick recovery which is beginning to show in a strong bounce from abysmal lows in several indicators: financial conditions, unemployment rate, retail sales and consumer sentiment all improve faster than expected causing the Citigroup Economic Surprise Index to hit an all-time high – a positive sign. But a majority of economists does not see a return to 2019 levels for several years.

The composite of leading economic indicators LEI (Conference Board Leading Economic Index) points to a deep recession. Chart from Advisor Perspectives.

Quick list of current key insights

• Current Market Environment: Bear Market and High Volatility Regime
• Basic Premise: Market Environments are sticky – trading with the trend will be profitable over the long term
• Uncertainty: High Volatility Regimes are hard to trade and the focus is on preserving capital for the next bull market
• Big Picture (two major scenarios are both likely):
  • 1) Bear Case: The coronavirus shock speeds up the usually drawn out top of a long bull market and this crash cascades into a longer economic downturn & severe bear market of -40% to -60%
  • 2) Bull Case: The coronavirus impact is strong, but temporary. Enormous stimulus acts like rocket fuel to propel economic growth to bounce back quickly 

My current market studies boil down to:
Breadth thrusts and recoveries, as we saw in recent weeks, have an almost unblemished record for higher prices over a 6-12 month time frame, but the surge in speculative activity (short /medium term negative) is now supported by a strong down thrust, volatility regime warnings and negative indications from Gamma Exposure levels.
I consider the situation over the next 2 to 12 weeks highly dangerous with probabilities in favor of further downside, but over the course of one year the picture looks increasingly brighter.

These insights are updated in detail (including a model portfolio) each Monday in my weekly report.
Preview a recent edition of the Meta Strategy Derivatives Portfolio newsletter here.

I wish you all the best in your life and your investing.

David

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